On several occasions recently, self-funded entrepreneurs have asked me about the merits of Angel Investors and Venture Capitalists.
A previous blog discussed the options entrepreneurs have for funding when it comes to financing their high-growth small business. Two of the options offered (Angel Investors and Venture Capitalists) are the source of many questions especially, “which one is right for my startup?”
Both Angel Investors and Venture Capitalists invest in businesses with high growth characteristics or potential. However, they have a different set of requirements when it comes to their involvement in the business and the types of businesses they are interested in.
This blog aims to provide more detail about Angel Investors and Venture Capitalists to help you decide which one is right for your business.
What are Angel Investors and Venture Capitalists?
An Angel Investor is an individual or group of individuals who invest their own money in a high-growth business. They are often highly experienced business professionals with knowledge of the industries they invest in. An Angel Investor will look for businesses that have incredible potential and will get involved at an early stage in the business’s development.
A Venture Capitalist is an institutional investor who manages other people’s money. They are looking for investments that will provide solid returns for their clients. Typically, a Venture Capitalist will help the business grow until it is ready for a stock exchange listing (initial public offer or IPO) or trade sale to a listed company. Both Angel Investors and Venture Capitalists make profits through capital gains when exiting or selling their investment in your business.
How do Angels Invest?
An Angel Investor typically has the following attributes:
They can invest individually or as a group
Most Angel Investors are individuals looking for a 4-8 year investment. Some Angels work in groups on businesses seeking significant funding.
They usually invest $50K to $1M of their own money
An Angel Investor is typically a successful business person who has accumulated significant wealth over their lifetime. They invest their own money in an enterprise they believe will be successful. Angel Investors typically invest between $50,000 and $1 million dollars per business.
Market sector or product/service experience/knowledge
Angel Investors will have excellent industry or technical knowledge of the businesses they investing in. They have often worked in the industry before or owned a business in the industry. This can be advantageous for your business as you are able to tap into their knowledge, experience and contacts which they willingly share.
Angel Investors seek minority equity investments
Angel Investors have little interest in providing loans to businesses or taking a share of profit. They seek minority equity ownership of the businesses they invest in. Many will seek a directorship in order to work closely with the CEO/Founder and influence business strategy. The Angel Investors aim is to assist the business to grow and make a profit on when their sell their shares on exit from the business either via an initial public offer or trade sale.
Angel Investors will Invest in the opportunity and people
Institutional Investors tend to look for businesses that are already profitable with a steady dividend stream. Angel Investors invest in businesses that show profit potential through scale up opportunities funded by their investment. They are attracted to unique businesses that possess disruptive innovation capabilities. That’s why an Angel Investor is more interested in tech startups than other investors. An Angel Investor will pay close attention to the key people managing the business they are considering investing in. A capable, experienced, driven and retained management team are key to getting funding from an Angel Investor.
Governance and control
Angel Investors will also look favourably on businesses that have an appropriate governance framework and internal controls that ensure the funds they invest are spent wisely. Angel Investors that request a directorship will expect regular formal meetings with timely financial reports and operations updates i.e. a monthly Board Pack.
Hands on approach via founder/entrepreneur coaching/mentoring
Because they are likely to have significant industry experience, Angel Investors will provide your business with excellent advice. Some will expect to provide Founder/CEO coaching/mentoring to ensure your business succeeds and manage their investment risk; so be prepared to receive, consider and even act on their counsel. This differs to Venture Capitalists, who may have less industry knowledge and be more demanding and contribute little.
Investor Terms & Conditions that protect their interests without being overwhelming
Angel Investors don’t seek to stifle the innovative flair of the Founder/CEO with restrictive investor terms and conditions. However, they will seek clarity when it comes to business valuations, stock dilution, capitalisation tables and other aspects they see as important to managing their investment risk.
Wants returns for all shareholders
The primary concern of an Angel Investor is business success in the medium to long term. They want all shareholders to receive a return on their investment and for the business to grow and become profitable. An Angel Investor doesn’t jump in and out of businesses — they want to see your business succeed and it’s value increase accordingly.
Understands and manages their risks
An Angel Investor achieves success through calculated investment decisions with managed risk. They will only invest an amount of capital that they think is appropriate for the business and the risks it faces in the medium-to-long term.
How do Venture Capitalists invest?
Venture Capitalists have the following attributes:
Institutional capital (other people’s money)
Venture Capitalists are institutional investors who invest other people’s money. When you work with a Venture Capitalist, you aren’t just working with a single person. You are dealing with a sophisticated business that includes board members, professional investors, and financial analysts. The money controlled by Venture Capitalists comes from many sources including corporations, high wealth individuals and superannuation funds.
Venture Capitalists have more money to invest
Because Venture Capitalists receive funding from many investors, they have more capital to invest. It is common for VCs to invest between $2 to $10 million in the businesses they work with. They may be involved in multiple rounds of fundraising, injecting more capital as the business grows.
Venture Capitalists like Angel Investors are interested in owning equity in your business. Similarly, once the business has grown or appreciate in value sufficiently, they will exit the company, selling their shares to the public (initial public offer or stock exchange listing) or a larger business (trade sale) usually with the assistance of investment bankers.
Venture capitalists are more likely to acquire a controlling interest in your business. They often do so to ensure that the business is managed well and continues to grow. This arrangement can help you reduce your risk, but you also lose control of your business.
Onerous Terms & Conditions with significant shareholder rights
Venture Capitalists come with more onerous terms and conditions for the businesses they invest with. They expect a high degree of control over and will bring specialists in to manage the business if they deem it necessary. This can include lawyers, business consultants, and accountants. While this may be a positive for the business, you may become disillusioned at the lack of influence you have over important business decisions.
Focused on returns for their investors/shareholders
A venture capitalist’s primary focus is on maximising the return on investment for their investors and shareholders. They achieve this return by investing in businesses that are further along the path to being cash flow positive and profitable but require significant capital for rapid growth to exploit available opportunities. A VC is more likely to be interested in more mature businesses that can scale up very quickly.
Require lower risks
Venture Capitalists are more risk averse, so they prefer mature businesses over startups. The kinds of risks they evaluate include market timing risk, business model risk, market size risk, execution risk, technology risk, and capitalisation structure risk. It will usually take a venture capital firm longer to decide if they want to invest in your business because they need to thoroughly evaluate its risk. There will be multiple meetings with different stakeholders and undertake extensive due diligence.
VC Fund returns go to Venture Capitalists and Fund Investors
Superannuation funds, managed funds, and individual investors invest in Venture Capital Funds to achieve a return of between 25% and 35% per annum over the lifetime of an investment. Each fund has specific rules about the industries and businesses they invest in and most funds have a limited lifecycle of between 7 and 15 years although it may be possible to extend the term with fund investor’s consent. Venture Capitalists will take a management fee (typically 2% to 3%) regardless of the VC fund’s results – to cover their salaries and operating costs. Venture Capitalists will also receive a share of the appreciation of VC fund’s value however fund investors get the bulk of this (typically 70% to 80%).
Invest in IP/technology – founders are dispensable
The intellectual property (IP) of a business is key to Venture Capitalists especially if protected by patents or patentable. That’s because patented IP can provide a valuable barrier to entry thereby increasing the value of a business that has exclusive use of that IP for the term of the patent. Venture capitalists are less focused on the founders of the business and aren’t overly concerned if they ultimately leave the business. However, if the Venture Capitalist views the founder or other key team members possess hard to find skills or knowledge essential for business growth and success they are likely to require some form of retention agreement prior to closing the deal.
The timing of investments by Angel Investors and Venture Capitalists
Angel Investors invest at an earlier stage of the business lifecycle than Venture Capitalists. They tend to show interest in the latter stages of product/service commercialisation or when the business has achieved local market validation. The capital provided by Venture Capitalists helps the business scale up and grow in new geographical markets.
In summary, early stage businesses requiring less capital and seeking the support of an experienced business professional without losing control of their business should consider Angel Investors to fund the commercialisation of their product/service. More mature businesses with local market validation of their product service, global scale-up opportunities that require more capital and business expertise with founders prepared to accept a minority share should consider Venture Capitalists.
More likely one will follow the other. If you’ve not explored Angel Investor funding then that’s a good place to start and will ease you into the demands of professional investors whilst retaining control of your business. As your business grows and additional funding is required then Venture Capitalists are likely your next move but be prepared for their demands and the likely loss of control of your business.
Either way you will be giving up autonomy so consider carefully why you first started your business.
Many small business are lifestyle businesses, generating sufficient income for the founders to be comfortable but unlikely ever to make the founders/shareholders extremely wealthy. Lifestyle businesses are unlikely to be attractive to Angel Investors and Venture Capitalists. If your business falls into this category it’s probably better to reinvest your profits or consider debt to fund new plant and equipment.
On the other hand, if you started your business to make a lot of money based on an exit strategy (generally the only time large profits arise), then your business will need to enlist the support, expertise and money from Angel Investors and Venture Capitalists to help you reach your goal.
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